Guest Post: The Foreign Exchange Market And CDS Spreads
Submitted by Douglas Borthwick of Faros Trading
The Foreign Exchange Market and CDS Spreads
We are continually amazed at movements in the foreign exchange market that come as a direct consequence of moves in peripheral 5-Year Credit Default Swaps (CDS). The chart below details the relative correlation of a GDP weighted basket of the relevant countries within the Euro. The relationship makes sense. When spreads blow out they do so because investor anxiety over Europe's credit position increases, anxiety over credit worthiness in Europe sees investors selling EUR/USD. However lately moves in the smaller peripheral components have been resulting in out-sized moves in the EUR. Something strange is a-foot.
The 'PIIGS', Portugal, Italy, Ireland, Greece and Spain, make up approximately 18.2% of a GDP basket-weighted Index. PIIG is only 6.34%, Ireland specifically makes up 1.75%, and Portugal 1.91%
However rumors today that Ireland and Portugal would require IMF assistance (something that would affect 3.66% of the overall basket,) resulted in the EUR/USD dropping from 1.3150 down to 1.3050. The rumors were later denied, and the CDS spreads came back in. However the damage was done.
What we are effectively seeing is price movement in the smallest and most illiquid markets (Ireland and Portugal 5 Yr CDS) dramatically moves the largest market in the world (EUR/USD spot). to put this disconnect into a more qualitative argument... While the CDS Spread in Ireland can be moved out by 10BPS by paying the offer in 15 Mio USD, thus resulting in the EUR/USD dropping 100 pips... In the FX market, someone would probably have to sell 3-5 Bio EUR/USD. Keep in mind it took the Japan's BOJ 22 Bio USD to move the USD/JPY price up 300 pips.
Given Ireland 5yr CDS moved out 15 Bps and its weighting in the basket is 1.75%, we would expect the news would contribute a widening of 0.2625 Bps. Given Portugal 5yr CDS moved out 25 Bps and its weighting in the basket is 1.91%, we would expect the news would contribute a widening of 0.4775 Bps.. Together the news should contribute about 0.74 Bps or .0074%. However the EUR/USD dropped from 1.3150 to 1.3050, or 0.8%...
As we stated above. It doesn't take much to move the CDS spreads, for example when a 20-50 Mio USD order in the CDS can realize a move equal to having sold 4 Bio EUR/USD. There is a disconnect.